Jason Day and Eric Louw, senior investment managers at Standard Life Wealth discuss their current positioning to the high yield bond sector.
'At Standard Life Wealth we manage over £1bn through our Managed Portfolio Service across an increasing number of platforms, with a choice of differing risk levels and two investment styles - Target Return strategies, which manage volatility and aim to deliver specific cash-plus returns, and Conventional strategies, which aim to deliver income or growth.
Both the Target Return and Conventional MPS have long-standing allocations to Global High Yield Bond funds. The Target Return portfolios have return objectives in excess of cash benchmarks and as such do not have a traditional asset allocation, preferring instead to be highly diversified across around thirty different strategies. We manage a range of five risk rated models, with target returns ranging from Libor plus 1% to Libor plus 4% net of fees. Our higher risk strategies within the range have the flexibility to take additional risk which can help us towards these targets. The Conventional MPS portfolios comprise of five multi-asset class, risk targeted models which include traditional equity and bond asset classes and alternative investments including global listed infrastructure and real estate investment trusts.
In our last article we mentioned that we had a preference for Emerging Markets Local Currency Debt and this asset class forms part of our high conviction weighting in these mandates. In addition, we also hold the Nomura US High Yield Fund as well as having a tactical weighting to US, Japanese and European equity funds.
The Federal Reserve’s continued path of interest rate normalisation has put fixed income under pressure this year however the Nomura fund has been extremely robust as the strategy specialises in lower-rated CCC bonds. At the lower end of the high yield credit spectrum, CCC has not sold off to the same degree as more interest sensitive bonds at the quality end of high yield and certainly far less so than investment grade US credit. In addition, over the year, the Nomura fund has benefited from the resurgence in the oil price as the fund has typically had an overweight to Energy, thus buoying returns for investors.
Despite the resilience of the strategy and the distinguished pedigree that Nomura has in identifying high yield credit, we have become less constructive on the prospects for US High Yield and have reduced our position.
One of the key drivers behind this decision is that credit spreads, i.e. the difference between high yield bond yields and US Treasury yields, are extremely tight and hovering around multi-year lows. Despite a sharp sell-off in the S&P500 in February which led to a savage short term correction in equity markets globally, US High Yield was largely insulated from this weakness. This is somewhat surprising as the trigger for the equity sell-off was concerns about looming US wage inflation and the imminent further advance of interest rates.
Although the default rate is low for US high yield and the asset class provides an attractive income stream, we feel that on balance the scope for future returns is limited given the significant spread compression. We have therefore taken some profits from Nomura and reinvested this into the Vanguard US Index Fund.
The economic backdrop for the US economy continues to be healthy. Job creation has continued apace, with unemployment now at 3.8%, the lowest since April 2000 having been as high as 10% during the global financial crisis. Whilst equity valuations are elevated, sentiment is high, corporate earnings are strong and the repatriation of offshore assets should support further share-buy backs, dividends and M&A which are all accretive for shareholders in US companies.
In Conventional MPS we have reduced our overweight to US High Yield in the income models, selectively increasing regional equities and we used the recent weakness in European credit to reduce our underweight to SLI European Corporate Bond and Schroder ISF European Corporate Bond funds, whilst still retaining a preference for Emerging Markets Local Currency Debt as our preferred fixed income overweight.'